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Questions and Answers
What economic event is considered the worst contraction since World War II?
What economic event is considered the worst contraction since World War II?
Which bank was sold to JP Morgan in March 2008?
Which bank was sold to JP Morgan in March 2008?
What was one of the primary reasons for the rise in interest rates during the Eurocrisis?
What was one of the primary reasons for the rise in interest rates during the Eurocrisis?
Which organization was NOT involved in rescuing Greece during the Eurocrisis?
Which organization was NOT involved in rescuing Greece during the Eurocrisis?
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What was a significant effect of the low interest rates from 2003 to 2006?
What was a significant effect of the low interest rates from 2003 to 2006?
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What crisis did AIG face in September 2008?
What crisis did AIG face in September 2008?
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Which country was the first to require a bailout during the Eurocrisis?
Which country was the first to require a bailout during the Eurocrisis?
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What was the immediate result of Lehman Brothers filing for bankruptcy in 2008?
What was the immediate result of Lehman Brothers filing for bankruptcy in 2008?
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What event during the Great Depression contributed significantly to agricultural decline?
What event during the Great Depression contributed significantly to agricultural decline?
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What was a primary characteristic of subprime lending during the Global Financial Crisis?
What was a primary characteristic of subprime lending during the Global Financial Crisis?
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Which tranche in a Collateralized Debt Obligation (CDO) is considered the highest ranked?
Which tranche in a Collateralized Debt Obligation (CDO) is considered the highest ranked?
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What issue contributed to the failure of mortgage rating agencies during the financial crisis?
What issue contributed to the failure of mortgage rating agencies during the financial crisis?
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Which of the following was NOT a result of the bank panics during the Great Depression?
Which of the following was NOT a result of the bank panics during the Great Depression?
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What role did Special Purpose Vehicles (SPVs) play during the financial crisis?
What role did Special Purpose Vehicles (SPVs) play during the financial crisis?
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What was a common problem with the underwriting standards in the US residential housing market leading up to the 2007-2009 crisis?
What was a common problem with the underwriting standards in the US residential housing market leading up to the 2007-2009 crisis?
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What commonly happened to firms with productive uses during the Great Depression?
What commonly happened to firms with productive uses during the Great Depression?
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What is a key characteristic of financial crises?
What is a key characteristic of financial crises?
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Which sequence accurately describes the initial phase of a financial crisis?
Which sequence accurately describes the initial phase of a financial crisis?
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Which of the following is a consequence of deleveraging during a financial crisis?
Which of the following is a consequence of deleveraging during a financial crisis?
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What typically causes a banking crisis within the context of a financial crisis?
What typically causes a banking crisis within the context of a financial crisis?
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How does debt deflation impact asset prices and debt levels?
How does debt deflation impact asset prices and debt levels?
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What role does moral hazard play during a financial crisis?
What role does moral hazard play during a financial crisis?
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Which of the following is NOT a way a financial crisis can initiate?
Which of the following is NOT a way a financial crisis can initiate?
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What is the primary effect of a stock market crash during a financial crisis?
What is the primary effect of a stock market crash during a financial crisis?
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Study Notes
Financial Crises
- Financial crises are major disruptions in financial markets, marked by a sharp decline in asset prices and the failure of firms.
- The key to understanding financial crises lies in studying moral hazard and adverse selection, even though regulations are in place to mitigate these issues.
- Financial crises follow a sequence:
- Initiation: Deterioration in financial institutions' balance sheets, declining asset prices, and heightened uncertainty.
- Banking Crisis: Economic activity shrinks, banking crises worsen the adverse selection and moral hazard problems, and lending contracts are affected.
- Debt Deflation: An unanticipated decline in prices leads to a worsening of adverse selection and moral hazard problems, further harming economic activity.
Causes of Financial Crises
- Credit Boom and Bust: Mismanagement of financial liberalisation or innovation can lead to a boom, but risks increase with weak incentives for risk management. Depositors may ignore risks, leading to losses and deleveraging.
- Asset-Price Boom and Bust: A bubble inflates asset values beyond fundamental value. When the bubble bursts, prices fall causing net worth to decrease, raising moral hazard and triggering deleveraging.
- Increase in Uncertainty: Major events like stock market crashes or financial institution failures cause uncertainty, triggering deleveraging.
Delevaraging
- Delevaraging occurs when financial institutions reduce their lending activities.
- This leaves no one to assess the health of firms, leading to financial system instability because the fundamental mechanisms to check adverse selection and moral hazard are gone.
- Financial institutions face deteriorating balance sheets and insolvency, potentially leading to bank runs and declining asset prices, potentially leading to a debt deflation.
Cases of Financial Crises
- The Great Depression: Stock prices doubled (1928-29) in the US before collapsing. Severe droughts in the Midwest severely impacted agriculture production, leading to credit troubles and bankruptcies for firms. Bank panics spread globally and impacted international trade.
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Global Financial Crisis (2007-09):
- Financial Innovation in Mortgage Markets: Subprime lending allowed less creditworthy borrowers to buy homes, but many couldn't afford the loans causing high defaults
- Agency problems in mortgage markets: Banks didn't care if customers defaulted, leading to significant risk.
- Role of asymmetric information: Credit rating agencies had meaningless ratings.
- Collateralized Debt Obligations(CDOs): Bundled bad loans into CDOs, with the riskier parts given less favorable ratings
- The European Sovereign Debt Crises(Eurocrisis): Before 2007, Eurozone countries had interest rate convergence. Afterwards, lower tax revenues and high public spending led to debt crises, with countries like Greece facing bailouts and affecting other countries.
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Description
Dive into the complexities of financial crises through key concepts such as moral hazard and adverse selection. Explore the initiation, banking crises, and debt deflation phases that characterize these market disruptions. This quiz will enhance your understanding of how financial systems react under stress and the underlying causes that lead to such crises.
